April 2018 Client Letter

The Post Parabolic Blues

Since the 10% decline in the S&P 500 index in late January I’ve been using my Bull Market playbook to deal with a decline. Technically speaking we are still in a Bull Market but our Bull status is looking more precarious by the day. The Bull Market playbook means I’m looking for a double bottom or retest of the market lows off the initial sell-off. Secondly, I’d be looking to buy stocks on signs of a successful retest and rally.

Friday’s 2.19% decline was especially disheartening since it wiped out three days of gains. Stocks had been showing signs of recovery by trying to build a base from which to rally. Previously, markets were appeased by the story that the White House was using the tariff threats as a negotiating tool. But Friday’s news showed that markets are not buying that story any more. This is a dangerous and unpredictable situation that leaves any investor unhedged in stocks vulnerable to policy mistakes and reckless statements from the White House or cabinet.

The second leg down rallies have been relatively weak with reduced volume while declines have been larger in magnitude and increased volume (not good). This reveals that large institutional investors are in a liquidation mode and are using rallies to sell rather than using declines to accumulate. This is Bear Market behavior and is giving me pause to reassess the likelihood of another another significant leg down for stocks and the possibility of a Bear Market.

Perhaps this weakness is the aftermath of the parabolic rise in stocks earlier this year? Plus the extreme readings of investor sentiment? It’s possible, but I’d argue that stocks and bonds are now reacting accordingly to an aggressive Federal Reserve and a much higher than average possibility of policy mistakes from the White House.

SPY Chart 1, Bull Market, Socially Responsible Investing

Chart 1

Chart 1 above, courtesy of Carl Swenlin of Decisionpoint, shows the importance of the $257 level for the “SPY” aka S&P 500 ETF. Both the 200 day moving average and the underlying trend line from the 2016 rally converge at nearly the same level.

There are also other important issues the world stock markets are contending with:

The global economic recovery is mature and slowing. Worldwide GDP data is showing clear signs of slowing.

Policy Errors: The tax cuts are the personification of fiscal irresponsibility and there’s no going back.

Trade Wars are “good and easy to win”. Investors aren’t fooled in the least by this rhetoric  (see Smoot-Hawley Tariff Act). We’ve never had a President who can just as easily talk up a stock market and talk it down with rhetoric within weeks. This is certainly a market headwind for stocks.

Yield Curve, Bull Market, Socially Responsible Investing

Chart 2

Aggressive Federal Reserve: The “Yield Curve” (shown above in Chart 2) is growing increasingly negative as short term interest rates are rising which will eventually kill the economic expansion. This causes investors to buy long term Treasury bonds. The higher short term yields and lower long term yield flatten the difference between short and long term rates which reduces the incentive for banks to lend.

The Yield Curve is a simple indicator and one of the most powerful tools to predict markets and the economy. Once the curve drops to .5 its “Goodnight Irene” for stocks and “Good Day Sunshine” for Treasury bonds. This is why we’ve recently added long term Treasury bonds to client portfolios.

If you’d like to learn more about the Yield Curve, there is an array of data from none other than the Federal Reserve:

https://www.clevelandfed.org/our-research/indicators-and-data/yield-curve- and-gdp-growth.aspx

Our Present Status: A sharp break in the price in Chart 1 below $257 without a rebound implies there is more selling ahead, which could be significant. Since my style of investing is based on reacting rather than predicting, I’d look for a $257 break to increase our existing hedges and further reduce stock holdings.

Should the price break below $257 not occur or occur briefly, I’d keep the status quo but expect the bottoming process to take longer than expected. I’d likely prefer to reduce stock holdings in strength until we see a positive change in market behavior.

Treasury bonds: My W.A.G. for Treasury Bonds and the economy is that the Yield Curve inverts in 2019 which will cause a full blown bear market in stocks and bull market in Treasury bonds. T-bonds could rally by more than 20% due to the reduced effect of lowering interest rates in an already low rate environment by the Fed. This could be followed by recession and bear market low by 2020.

Bottom Line: I’m agnostic to market direction as we can generate profits in accounts regardless of market trends. It’s the transition periods which we are possibly in that are tricky to assess. Once a new trend emerges, be it up or down, I’ll adapt and do my best to continue generating profits on your behalf.

Thank you,

Brad Pappas


Disclaimer, Socially Responsible Investing






Coolest chart of the Week – 1/26/18

Volatility ETN’s like VXX appear to at least be putting in a short term bottom. Eventually Volatility will increase and the VXX could rise substantially. Long VXX.

QE’s impact on markets and model portfolio performance

Not since 1995 has the S&P 500 not had at least a 10% pullback.   Normally, you can count on a 10% pullback within an ongoing bull market to a great time to add funds or bring new accounts online.  But 2013 is the year of the relentless rally where 2% pullbacks are new 5% pullback.    Extreme bullish investor sentiment which is normally a good barometer of when to ease up on portfolio exposure has been pointless, as previous blog posts have demonstrated.

So, whats going on you ask?   Why is this year different from the others and what does it mean going forward?

Markets are clearly being driven higher by the Federal Reserve current policy of Quantitative Easement and its by product of 0% short term interest rates.

Its no coincidence that when the Fed ended QE1 and QE2 markets fell apart with declines of -16% and -19% respectively in 2010 and 2011.

Its fashionable right now to analyze each economic tick (especially the recent positive employment data) to determine when the Fed will end QE3.   But the truth is we really don’t have an accurate guess for when that will happen.

Three things we know for sure at the moment:

1.  We are in the midst of the strong season for equities and that will last until March 2014.

2.  The economy as measured by employment is improving.  Contrary to politically biased media outlets job growth is not coming from part time employment.   GDP growth in the 3rd quarter was stronger than expected.   This is market friendly.

3. Bob Dieli’s Aggregate Spread and RecessionAlert.com are both at benign/miniscule odds of recession.  Market friendly again.

My best guess of what will happen?  Eventually the Fed must end QE3 and the markets may anticipate this ahead of time by churning nowhere or showing internal deterioration in strength.    My thinking is that the Fed will do nothing till at least after congressional budget talks in January but by the time March comes around and temps here begin to melt some snow we should be decreasing our equity exposure in a meaningful way.

QE effects0001


No recession in sight

Music in the background:  The Black Keys  “Have Love Will Travel”.   I’ll pull no punches I love listening to the Black Keys especially at the gym.  But, for all their appeal has there been a band that has borrowed from more artists?   Bo Diddley should be collecting some of their royalties.

Frequently, we have to tell clients to ignore the noise of the media which will bombard the investor with combinations of fear or euphoria bordering on the manic.  Frequently those opinions are jaded with political or investment biases which make their statements virtually worthless.   Even more frustrating are the multi-handed economists who never appear to make a decisive stance “On one hand, then on the other hand etc.)

Its essential to tune out the noise and find sources of information that are purely data driven without biases and one very good source is Recessionalert.com (RA)

This morning RA released their Long Leading Index (USLLGI) and I’ll use their own words to describe the USLLGI:

“The USLLGI takes a far-reaching forward view of U.S economic growth by tracking 8 reliable indicators which have consistently peaked 12-18 months before the onset of NBER defined recessions since the early 1950?s. The growths of these indicators, together with their diffusion index, are combined into a 9-factor composite to give a generalized view of future overall U.S economic growth. When the USLLGI falls below 0 for 2 consecutive months you have a signal that recession will occur in 12-18 months.”

This is an economic timing method not a stock market timing system.   The lead times are long, for example in the 2007-2008 “Great Recession” the LLI tipped its hand in early 2006 by crossing over the 0 level.  In 2011 it made a near miss by approaching 0 but it never broke through.   At present its at a healthy reading of .1 which largely eliminates the chances of recession in 2014.   Its too early to say for 2015 but we’ll have an idea by the end of this year.

In the meantime, ignore the fear and noise.  The potential for a new secular bull market has some real potential.

Be careful out there

Brad Pappas